Buying puts can be a less capital-intensive way to gain short exposure to the shares without short-selling shares outright. However, long options suffer from time decay, and the value may decrease each day the underlying does not move toward the strike price. As a result, the underlying must drop at a greater velocity towards the put options' strike price to make up for lost value.
Out-of-the-money (OTM) puts are usually cheaper than in-the-money (ITM) puts. That is because the value of an OTM put is entirely made up of extrinsic value. ITM puts will have intrinsic and extrinsic value, resulting in a higher cost per contract. Over time, the extrinsic value of all options decays to $0.00 as expiration approaches. Meanwhile, ITM puts will retain their intrinsic value at expiration, and any extrinsic value will decay down to $0.00 near or at expiration.
The ideal scenario of a long ITM put option is to have the underlying drop as much as possible, so it gains intrinsic value and is worth more at expiration than what the trader purchased the put option for upfront. This is the same scenario for OTM put options as well, since OTM put options need to move ITM at expiration to retain any value at all. Prior to expiration, OTM and ITM put options can gain extrinsic and/or intrinsic value if the stock moves swiftly to the downside as well.
Long put options that expire ITM by $0.01 or more will be auto-exercised. Investors only holding a long put will result in 100 short shares* per contract sold at the put option's strike price. Investors holding the corresponding long shares will sell their long shares at the put contract's strike price. It's important to note that investors who want to avoid the long put contract from auto-exercising for expiring ITM may sell the contract before the market closes on the expiration day. Any long put options that expire OTM will expire worthless, resulting in a maximum loss for the investor. The following section covers more about potential profit and loss of a long put..
Any account holding a long put subject to expiration risk may be closed out by the risk team. Please visit the Help Center to learn more about expiration risk.
Profit & Loss Diagram of Purchasing an OTM Long Put
A long OTM put becomes profitable when the current value of the option exceeds the purchase price. This can occur prior to expiration if the stock moves towards the strike and increases the extrinsic or intrinsic value of the option, or at expiration if the stock moves well below the strike price. The max profit of a long put is not unlimited, unlike a long call, since the most a stock can drop is to $0.
Losses on the put option can occur if the underlying does not surpass the breakeven point, as illustrated where the red and green zone converge on the x-axis. The breakeven point can be calculated at expiration by taking the strike price and subtracting the purchase price of the OTM option. Since OTM options are purely made up of extrinsic value, the strike needs to move ITM and take on an equivalent amount of intrinsic value at expiration to breakeven.
The maximum loss on a long put is the debit paid for the option, which the flattened red area of the diagram illustrates.
